The hedge fund industry should adopt a fee structure that more effectively ties managers’ compensation to the performance of their funds, Som Seif, president and CEO of Claymore Investments, Inc., said on Thursday.

Seif participated in a debate on hedge fund fees held by the Alternative Investment Management Association Canada in Toronto. He argued that the management compensation structure in the hedge fund industry is rewarding managers based on the level of assets in funds, rather than fund performance.

“There has been an enormous influx of capital into the hedge fund industry,” Seif said. “It all but guarantees that hedge fund pay in the coming years will not be as closely tied to performance as it has been in the past.”

Seif explained that base management fees, which were originally set up to cover operational, back office and other overhead costs of running a business, have become a significant part of overall compensation for many managers.

These fees, according to Seif, “were not meant to be used as a profit incentive – that’s instead what the performance fee was meant to be.” Using base fees to compensate managers means they’re rewarded even when their fund performance is weak.

“The base fee guarantees strong cash flows regardless of performance,” Seif said.

Jim McGovern, CEO of Arrow Hedge Partners, argued that the compensation structure in place works effectively.

“The correct incentive structure leads to better results,” he said. “Incentive fees are a critical part of compensation, and obviously, very motivating.”

The fees that hedge funds charge are justified by the fact that they produce higher returns and lower volatility than equities, McGovern added.

“The steadier long-run returns associated with hedge funds are indeed worth the price when examined at a very high level,” he said.

In years when hedge funds failed to produce positive returns, such as 1998 and 2008, McGovern pointed out that the losses incurred by hedge funds were less severe than those incurred by equity markets.

Seif agreed that hedge fund managers who produce alpha deserve to be compensated. “Managers who can consistently create alpha should be able to charge for their skill,” he said, adding “the better you are, the more assets you should have, and the higher your fees should be.”

But he argued that fees charged should reflect a specific fund and its performance, and should not be standardized across the industry.

Seif also called for more disclosure from the hedge fund industry.

“If investors understand what they’re buying, then I think everyone will be happier,” he said.

IE